Four Reasons the Stress Tests On Banks Could Hurt Stocks

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Wall Street's belief that bank stress-testing would be a non-event for the stock market has changed, and investors may not like the results.

The government's efforts to analyze whether the nation's 19 largest banks have enough operating capital to avoid federal cash infusions had been receiving scant attention—until serious questions began to arise over whether the process was flawed.

Concerns about transparency and whether the government has set the bar high enough to declare that a bank has adequate operating cash have some worried that a market that is perhaps overbought might suffer once test results trickle out.

"Most investors have basically written off the stress test, but it also has the potential to do damage," says Quincy Krosby, chief investment strategist at The Hartford. "They have to be very careful. This is going to require a tremendous amount of tact and diplomacy on the part of the administration."

Investor concerns over the stress tests, the results of which will be released in May, break into four categories:

1. Lack of Transparency

As the results of the test get closer to release, the Wall Street rumor mill has churned into overdrive.

The Obama administration has fed water cooler chatter by vacillating on how much will be disclosed. Initial indications were that the administration wanted the results kept private, for fear that banks that did not grade as well would generate panic among investors and depositors alike.

That's a position that hasn't set well with Wall Street, where uncertainty is often met with selling.

"It does depend on how transparent they are," says Dave Lutz, managing director of trading at Stifel Nicolaus. "The market hates the unknown more than it hates bad news."

Had the administration been clearer on how the tests were going to be conducted and how the news would be released, that would have soothed some fears that a large and unexpected shoe could be dropped.

The alternative, then, "would have been to lay out the plan and announce it fully so investors knew what they were going to do from the beginning, rather than have the rumor mill generate the plan," Krosby says. "What happens now is it looks as if the administration is reactive rather than proactive."

2. No One Gets an "F"

At the core of the tests is the notion that none of the banks involved is actually going to "fail" the test per se.

Stronger banks will emerge as winners and will not need federal bailout money, while weaker ones will not be allowed to go under but instead be given more time to raise capital as well as government assistance to do so.

That creates a sort of economic bell curve that has some analysts worried about the future of an industry in which bad businesses are artificially propped up--perhaps at the expense of good ones.

"The administration's approach seems to be we're going to have a no-bank-left-behind attitude," says Mike Larson, an analyst with Weiss Research. "The reason there's so much uncertainty and mistrust in the financial sector is we're not being forthcoming about who's strong and who's weak."

That atmosphere doesn't translate well into the investment sphere, where clear information is key.

"The bottom line is by keeping things too secret and agreeing to prop up everyone and not dealing with euthanizing these other institutions, you risk dragging down the strong with the weak," Larson says. "As far as short-term impact with bank stocks, the guessing game of who's weak and who's strong are the kinds of things that lead to short-term gyrations."

A perception that the standards are low for banks in terms of economic projections and capital needs also could cause problems.

"The main reason the stress tests could cause another leg down would be a very weak stress test in the sense that they really didn't push the scenarios on the banks," Lutz says. "That's one issue that could knock us down."

3. Will Anybody Believe the Test Results?

Along the same lines, confidence in government has been on a decided wane since Washington got involved with the credit crisis.

The botched public relations campaign and a feeling that the government is setting the bar too low regarding the tests has some worried that the results may not be taken seriously by investors.

"There's just a lot of concern, period, for anything the government does and how well thought through it is," says Kathy Boyle, president of Chapin Hill Advisors in New York. "Forcing everybody to take money solves that immediate crisis for moment, but all they did was delay the problem for six months."

Even those who believe the worst has passed for banks foresee skepticism from the stress tests.

"No matter what the government is going to do right now in regards to this test, somebody's going to be able to pick it apart," says Gary Hager, president of Integrated Wealth Management in Edison, N.J. "It doesn't seem to matter what the government does. It's second-guessed at all levels."

Hager is in the camp that the recent tumult over the stress tests is overheated and that the major banks will emerge fairly unscathed.

But that sentiment drives back the point of whether a report that shows the industry in relatively good health will have credibility.

"So much depends on the way the administration delivers the information," Krosby says. "You've got to wonder--are they going to point the finger at the weaker banks and allow a run on them?"

4. Stocks are Due to Fall, Anyway

In a market that is on a five-week tear higher, any bit of bad news could be a catalyst for a leg lower.

"When a market is due for a pullback they'll use any excuse to do that," Krosby says.

Should news break that a big bank came through the test poorly and will need to recapitalize--and thus be denied the ability to be aggressive in the marketplace--that could spur a selloff and drag the stock indexes lower.

Some point to the recent Goldman Sachs (NYSE: GS) results in which the company easily beat Wall Street expectations but suffered losses to stock price. Investors worried after examining Goldman's numbers at whether the profit was built on solid ground.

"If you get a day where there's news like Intel (NASDAQ: INTC) or Goldman where people look inside the numbers and question why they're doing what they're doing, I think you're going to run the risk of having a big selloff," Boyle says.

An attack on bank stocks would be sure to send the broader market lower.

"It's an important part of the puzzle. It's not the be-all and end-all but it's a very significant part of the mosaic and analysts are trying to piece together whether there's demand being created," Krosby adds. "Obviously, the financials are a key part of that puzzle. Without the financials stabilizing it's hard to see how we really pull out of this."